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Habit Formation and Interest Rate Smoothing

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  • Luisa Corrado

    ()

  • Sean Holly

    ()

Abstract

Following a conjecture of Kozicki and Tinsley (2002) we generalise the habit formation model of consumption to allow for both a multiplicative utility function and a habit-aspiration function which is a geometrically weighted average of past consumption. The geometric form of the aspiration function addresses the recent concerns of Wendner (2002) who shows that a combination of a multiplicative utility function and an aspiration function that is an arithmetic weighted average of past consumption violates some important assumptions of utility theory. In addition, the geometric form allows us to derive an optimising model of the IS-PC form in which there is a greater degree of inertia in both inflation and output that arises from the role given to habit formation. Because the welfare function of the policymaker is that of the representative agent, and consumers dislike large changes in consumption relative to the level of consumption to which they aspire, the optimal (one-period) rule penalises changes in income and also responds sluggishly to shocks. This goes some way towards accounting for the common observation that the responses of output and inflation to shocks are drawn out, and the interest rate used for policy is persistent. We calibrate the model and find that we can replicate the persistence in interest rate setting by a monetary authority over and above that attributable to the persistence in inflation and the output gap.

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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Conference Paper Series with number 0404.

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Date of creation: Sep 2004
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Handle: RePEc:san:cdmacp:0404

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Keywords: Habit formation; interest rate smoothing; AIM method.;

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Cited by:
  1. Arnab Bhattacharjee & Sean Holly, 2006. "Taking Personalities out of Monetary Policy Decision Making? Interactions, Heterogeneity and Committee Decisions in the Bank of England’s MPC," CDMA Working Paper Series, Centre for Dynamic Macroeconomic Analysis 200612, Centre for Dynamic Macroeconomic Analysis.
  2. Chadha, Jagjit S. & Holly, Sean, 2010. "Macroeconomic models and the yield curve: An assessment of the fit," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 34(8), pages 1343-1358, August.
  3. Alessandro Flamini & Andrea Fracasso, 2009. "Household’s Preferences and Monetary Policy Inertia," Working Papers, The University of Sheffield, Department of Economics 2009002, The University of Sheffield, Department of Economics, revised Feb 2009.
  4. Michael Funke & Sebastian Weber & Jörg Döpke & Sean Holly, 2008. "The Cross-Section of Output and Inflation in a Dynamic Stochastic General Equilibrium Model with Sticky Prices," Quantitative Macroeconomics Working Papers, Hamburg University, Department of Economics 20809, Hamburg University, Department of Economics.
  5. Sharon Kozicki & P.A. Tinsley, 2007. "Term Structure Transmission of Monetary Policy," Working Papers, Bank of Canada 07-30, Bank of Canada.
  6. Arnab Bhattacharjee & Sean Holly, 2005. "Inflation Targeting, Committee Decision Making and Uncertainty: The Case of the Bank of England’s MPC," CDMA Working Paper Series, Centre for Dynamic Macroeconomic Analysis 200503, Centre for Dynamic Macroeconomic Analysis.
  7. Bhattacharjee, A. & Holly, S., 2005. "Inflation Targeting, Committee Decision Making and Uncertainty: The case of the Bank of England’s MPC," Cambridge Working Papers in Economics, Faculty of Economics, University of Cambridge 0530, Faculty of Economics, University of Cambridge.
  8. Jagjit Chadha & Sean Holly, 2006. "Macroeconomic Models and the Yield Curve," Computing in Economics and Finance 2006, Society for Computational Economics 105, Society for Computational Economics.

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